For the most part economic debate can revolve around the margins, with few bold ideas promulgated. This week however, Senator Nick Xenophon proposed a major shakeup to the way economic policy is run. He is proposing the Reserve Bank shift from its nearly quarter of a century policy of targeting inflation to instead targeting nominal GDP growth.

It’s an idea that deserves discussion if only to shake us out of the rut of the “new normal” of low growth and low inflation.

Firstly, a bit of history is needed.

In the 1970s after two decades where inflation averaged 2.6% annual growth, prices took off while economic growth stagnated. In the 1970s and 1980s inflation growth average 9.3% annual growth.

Not good.

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Most countries around the world were having the same problems, and the response was for central banks to target inflation rather than full-employment or economic growth.

Interest rates were jacked up – in the USA in the early 1980s and here in the 1990s. It broke the back of inflation and it broke it across the backs of workers as deep recessions followed.

But since the early 1990s, inflation has basically been kept in check – since March 1991 Australia inflation has averaged 2.5% – right smack in the middle of the RBA’s target of 2%-3%:

Inflation targeting was the solution to the problem of ongoing high inflation.

But we are no longer in that world – the opposite in fact.

The policy was also sold as being the key towards solid, stable growth. And it certainly worked … right up until the moment it didn’t.

Yes, during the 1990s and early 2000s there was low inflation, solid growth, and declining unemployment.

And then the GFC hit here, and the northern hemisphere had The Great Recession. Enough to give you pause to consider that perhaps economic policies are not infallible.

Senator Xenohophn’s response this week has been to argue that the RBA should stop worrying about inflation, and instead should target stable nominal GDP.

Now this is not a new idea.

In the USA it has been doing the rounds since 2010 when economists such as Scott Sumner on his blog “The Money Illusion” began talking up the idea. In Australia John Quiggin was writing on the idea in early 2012, and in February 2012, then ALP backbencher Andrew Leigh asked then RBA Governor Glenn Stevens about it during a House Economics committee hearing.

We normally talk about “real” GDP when we talk about GDP growth – as that is the measure of the real change in economic output. Nominal GDP is just real GDP plus inflation.

Those in favour of the idea argue that stable nominal GDP growth is a better measure of economic health than is stable inflation.

Generally the target thrown about is 5%-6% annual growth – because that is roughly the sum of average inflation growth of 2.5% plus average output growth of 3%.

But the big difference is when targeting nominal GDP growth you don’t care how you get there. If output growth is 1% and inflation is 5% then in effect that is no better or worse than if output is growing by 5% and inflation 1%, as both would see nominal GDP growing by 6%.

The reason nominal GDP targeting is favoured now is that our current nominal GDP growth is historically weak:

Not only is it at levels you would normally associate with a recession, we are also in the very bizarre situation where real GDP growth is higher than the nominal growth rate – which means that the inflation measure used for GDP figures is negative – ie prices are falling.

This goes to both the reason for nominal GDP targeting and the problem with it.

The nominal GDP measure can get pretty erratic in Australia because it is influenced greatly by wild changes in our terms of trade.

This is because, unlike the CPI, the GDP deflator (which is the inflation measures used in the GDP figures) includes changes in the prices of our exports as well as many non-consumer items. It makes for a much more jumpy measure of inflation:

Were the RBA to target nominal GDP it would likely need to factor out much of those wild swings lest it be jacking up interest rates just because iron ore prices took a jump.

Critics on nominal GDP targeting suggest that would in effect mean just using the CPI figure like they do now.

A look over the past two decades suggests that the RBA’s decisions on interest rates were not completely unconnected to nominal GDP growth:

During the mining boom period while inflation remained below 3%, the RBA kept increasing interest rates. And after the GFC, they cuts rates in line with nominal GDP falling.

The key difference is that during the mining boom interest rates would have be pushed higher, and it is likely they would be cut lower now.

Critics of the idea – such as the AFR’s Jacob Greber – suggest this would mean the RBA would be setting fire to the housing market and would more likely to lead to asset price bubbles.

That certainly could happen, although had the policy been in place prior to the GFC, higher interest rates would have put a dampener on house price rises and the subsequent mad growth in household debt.

But one key difference would be that changing the target from inflation to nominal GDP would put more pressure on the government to use its fiscal measures.

One of the big problems with our current low nominal GDP growth and declining income growth (the ABS’s measure of economic well-being) is that there is little sense of the government and RBA acting in sync:

With the current policy, the worry is always that were inflation to rise due to fiscal policies, then the RBA would raise interest rates.

Thus we had the absurd situation last year where then Treasurer Joe Hockey was claiming the RBA had “room” to cut interest rates because the Abbott government’s spending cuts meant it “had been able to control the inflation genie”.

He said this at a point when underlying inflation hadn’t been above 3% for five years and nominal GDP was growing by just 1.3%.

Targeting nominal GDP resets the conversation.

Rather than having the government cutting spending (which reduces growth) in order to allow the RBA to cut interest rates to stimulate growth, both the fiscal and monetary arms could focus on improving growth – and it would put more pressure on the government rather than the current situation where it is leaving most of the work up to the RBA.

Given government revenue has been hit due to the decline in nominal GDP growth, making that a focus would also assist with improving the budget balance.

There are of course issues to consider.

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Firstly even acknowledging the GFC, our own economic performance under the inflation target has not been too bad, and the past 25 years have been historically excellent. But equally true is that since the GFC – over six years now – growth has been weak.

It would take some getting used to – it would be odd to have the RBA cutting rates when inflation was running above 3% if output was less than 2%. But having to get used to something is no reason not to do it.

After a quarter of a century of doing something it is tempting to stay in our rut and keep believing everything is fine and we’re doing as best we can do.

But we should remember the inflation targeting system was introduced to solve a problem that no longer appears to exist. There are a lot of things that looked good 25 years ago that are sadly out of date now.

Senator Xenophon’s call is worthwhile – and even if the RBA does not change its target it should spur a conversation about the effectiveness of our monetary and fiscal policies.